JAMES BURNS, a partner at Smith & Williamson, explains why investment trusts are favoured by firms that manage private client portfolios. (Note: this interview was first published in the 2019 edition of the Investment Trusts Handbook and has not been updated since).
Why are investment trusts popular with wealth managers?
James Burns: Investment trusts have always been popular with wealth managers, and have become more so in recent years as more and more asset classes have opened up as options in the investment company space. As the sector has morphed from consisting mainly of conventional UK-registered companies into a much broader investment universe, we have become even bigger supporters. We are always among the first to get an early call for brokers promoting new launches.
The sector has changed a lot since the financial crisis. Up until then it was primarily equity trusts. There was a very small fixed income sector and we had a big boom in property investment companies leading up to the financial crisis. Hedge funds also came in for a while. But since the financial crisis there has been a massive explosion in different asset classes to access. The easy explanation is that the banks have come out, or at least had to retreat, from many parts of the market. So now we have things like commercial property lending, aircraft leasing and more specialist property sectors, such as student and healthcare property. There have been a few more private equity launches too.
Overall there are far more different asset classes to play with now. The financial crisis has been good for the sector in that respect because the investment company structure is an absolutely ideal vehicle for these less-liquid pools of capital. At the same time, the investment company sector has really benefited from wealth managers looking to build diversified multi-asset class portfolios, an approach which is becoming much more common.
How do you use investment trusts within the firm?
JB: One is as a core building block for a portfolio. Conventional equity investment trusts such as MONKS and SCOTTISH MORTGAGE have good management teams and are very attractively priced these days. The sector also offers good income vehicles with revenue reserves and good historic payout ratios. With trusts whose managers have the ability to invest in smaller and less-liquid shares than they are allowed to do in their open-ended funds, you are hopefully getting their best ideas as they can afford to take a longer-term view.
The second attraction is the ability to access multi-asset trusts which give you diversification away from conventional equity and bonds, whether that is in the form of commercial property lending, renewable energy or whatever. I always look at the sector in these two ways. The key thing for me is that natural selection works in the investment company sector. If you are not performing, or the management house is not performing, shareholders and boards are much more active now. Poorly performing vehicles will die out. Dead wood gets kicked out relatively quickly.
Do you expect fees to continue coming down?
JB: Yes. There is certainly a long list of funds that have cut performance fees in the last few years. I think that boards of trusts now realise that they are able to assert their strength in negotiations with management houses over fees. Their argument is that as investment companies have the advantage of permanent or semi-permanent capital, so their fees should be coming down. Trusts like the ones I mentioned, Monks and Scottish Mortgage, are now charging incredibly attractive fees for active management.
Are trusts doing too much or too little by way of using gearing?
JB: On the whole I think the use of gearing has been pretty good. There are different approaches. Some boards are involved in every gearing decision. Others give managers leeway up to a certain level. Some trusts say that as we have a longterm view, we are going to be geared pretty much all of the time. Other managers look to reduce gearing when they think that valuations are looking potentially stretched. We have seen very few increasing their gearing recently.
What about the added volatility that shares in investment companies have?
JB: You can’t dispute that trusts will be more volatile than open-ended funds in terms of price because of the supply-and-demand dynamic and also potentially because of gearing. We always say that, if it is part of a sensibly constructed portfolio and if you are happy with the level of volatility, then investment companies make absolute sense. A lot of people use the sector for income and as long as that income is being paid, that is the key thing. In 2008 in the equity income sector, only one trust cut its dividend. Every other trust in the sector held its dividend while open-ended funds were cutting. That is important for clients because they want to know that their income will keep on growing and they can afford to hold for the longer time.
Are the regulators doing enough to promote investment companies as an alternative?
JB: The Financial Conduct Authority has probably been showing a bit more interest lately. The AIC lobbied hard to make sure that investment companies are not classified as complex investments under the latest European legislation. The truth is that investment companies are slightly more complicated investments, but it is really just a case of having a few more moving parts to look at. You have to do a bit more research. The good thing about investment companies that needs to be emphasised is that in this post-RDR, governance-driven world there is a board of directors there to protect shareholders’ interest, which is a big positive.
But has the quality of investment trust boards improved? They were the butt of many jokes not so long ago…
JB: Over the last decade boards have been showing far more independence over fees and moving management contracts around. We have seen more examples of directors taking their responsibilities more seriously than they were. There is definitely still room for more improvement. I can think of a couple of cases recently where boards have failed to bite the bullet and move the management contract when they should have done.
Are you in favour of more boards introducing discount controls?
JB: I am actually quite relaxed about that. I am still of the view that there are few things more fun than buying a really good investment trust that is trading on a discount because of some short-term wobble in the market. What I don’t like to see are boards turning to cash registers at the wrong time, purely because they have put a line in the sand. The risk is that they end up shrinking the trust to a point which may not be in the interest of everyone. That said, what you don’t want are no controls at all and boards adopting a laissez-faire approach, with a discount staying at 20% forever. I quite like the idea of trusts with a fixed life, giving us as investors the ability to get out after a few years. While the discount may move out a bit in the short term, you know that on a three- or four-year view you can exit at NAV.
Is there a limit on how large a trust has to be for you to invest in at IPO?
JB: Ideally we are looking for investment companies with £100m in assets, but we won’t say no if it is less than that, particularly if we think it has the potential to grow, and will be able to raise more money with secondary issues. There is no one absolute limit. £100m is our unofficial limit. At some other houses it is £250m. I can understand why they do it, but it also means that there are trusts in the area that they don’t consider at all, so they are missing out on some very good vehicles. While we monitor our holdings, we do allow exceptions. We think our approach is more flexible.
What has been the driving force behind the wave of recent launches?
JB: Yield has been a big driver of new issues and that makes sense. Things like REAL ESTATE CREDIT INVESTMENTS we really like because you are getting attractive income yields from the lending and still have an equity cushion above you. If you buy Land Securities, by comparison, you are just taking the equity risk, so if you can get 6% yield on real estate lending, that is attractive. The search for income has been a particularly big factor behind all the new issues in the alternative asset space. In 2017 nearly all IPOs had an income story behind them. PERSHING SQUARE, one that wasn’t, was a big launch that has not been particularly successful. This year, however, we have seen some interesting new issues in the conventional equity sectors.
Are you not worried that income-based IPOs are becoming too much of a fashion thing?
JB: Yes. I am becoming a little concerned. The investment company market does have a tendency to get quite excited about certain asset classes. Some of the issues recently have become very niche-specific, particularly in the REIT space.
Has the alternative asset sector grown too far too fast? Some of them seem to be running out of opportunities…
JB: I have some concerns on that score, but there have been further bright spots too. The bid for JOHN LAING INFRASTRUCTURE earlier this year at a 20% premium showed that there is still interest in the assets among large institutional players in the market. Some trusts like CARADOR are winding up, and there are others which have not quite done what they were meant to have done, but the positives still outweigh the negatives in my view. As income sources they have mostly been great for private clients.
How has your view of the outlook changed over the past 12 months?
JB: The whole investment trust sector has done incredibly well since the financial crisis. It has grown in size, there have been lots of success stories and the alternative asset trusts have introduced some great new choices for investors. It is probably only natural that we should have turned a bit more cautious now. Both the sector and the markets would probably benefit from a pause for breath.
In general we still think the outlook is positive for both bonds and equities. Interest rates are rising, but slowly. Of course the markets are vulnerable if we get an inflation shock, particularly in the United States. I am probably a bit more cautious than some of my colleagues, but for now the outlook appears to be relatively benign. Let’s hope that it stays that way.
What changes have you made to your portfolios over the last year?
JB: We have not made a huge number of changes. We have taken a bit of profit on our private equity trusts. SYNCONA has been a terrific performer for us and so we have sold that down a bit. We first bought in at the launch price of 100p and it has more than doubled since then. We never expected it to do as well as it has so quickly. It has still got exciting long-term prospects, but we won’t be chasing it at this price. We have also added a holding in DIVERSE INCOME TRUST on the view that it will provide some portfolio protection as a diversifier. In general we have become slightly more defensive.
With the markets being quite richly valued, and discounts tight by historical standards, it has been hard to get too excited. We have mostly been looking out for specific opportunities rather than adding to existing positions in the market leaders. For example we added a holding in RIVERSTONE ENERGY earlier in the year, on the view that the oil markets were likely to be stronger than most people had thought, and the discount had gone out a lot. The UK income trusts have taken a bit of a beating, too, which could become interesting.
And you have been sticking with Mark Barnett’s trusts, which have underperformed for some time now?
JB: Yes we have. I have probably had more grief about that from my colleagues than anything else! However, I don’t believe that Mark has lost the ability to run money. There is always a danger of overreacting to a run of poor performance. His value style of investing has gone massively out of favour but I hope – and expect – that the performance will come back, although it may take a change in the market environment before it happens. [Editor’s note: Barnett is the manager of both the EDINBURGH INVESTMENT TRUST and PERPETUAL INCOME AND GROWTH, which together have assets of more than £1.1bn.]
Have you been taking stock in this year’s IPOs?
JB: We have done a few. We supported Baillie Gifford’s new American trust, for example, which has already done remarkably well, given how tough it is to outperform in the US market. They are in a bit of a sweet spot at the moment; everything they touch is doing well. Mostly, though, we have concentrated on secondary issues. We are going to be seeing Mark Mobius to talk about his new emerging markets investment trust and there is also a new Japanese trust that Asset Value Investors are hoping to launch which looks interesting.
What do you think will happen to discounts if the market does have a significant downturn?
JB: If the tide does turn, then discounts will obviously come back off current levels, but by how much is an interesting question. We have been looking for opportunities to add some further portfolio protection, as I mentioned. It is not that easy. Trusts that have a fixed life offer some protection, as you know that you can get out when the wind-up date comes round. Of course, if discounts do widen a lot, that could be a good buying opportunity, and I would hope that we could profit from that. Nothing is ever black and white in this business!
JAMES BURNS is a partner in Smith & Williamson and responsible for leading the firm’s research into investment trusts. He also manages three multi-manager funds that invest in investment trusts and a number of private client and discretionary management portfolios, and co-manages the firm’s Managed Portfolio Service.